One of the challenges for cleantech VCs, and for VCs in general right now, is the potential negative selection bias that comes from being a large fund. This particularly applies to the large, big-name firms that adopt a "go big or go home" perspective when it comes to their investments.
Many such large funds have minimum ownership targets -- they want to own at least 20% of the company they invest in, so that if it's a big success, they end up with a big return, which makes sense, right? This is rarely a hard-and-fast rule, although it's often presented as such. But whether it's a hard floor or not, big firms don't want to own only a small piece of the companies they invest in, unless it's a really obvious high flier like a Facebook or such.
What this means in practice, however, is that when they're coming in as an outside lead in a Series B round, they need to either have it be a pretty low valuation, or they need to put a lot of money at work, especially as insiders will also want to exercise their pro rata rights. For instance, let's run through some really basic math to illustrate this point.
If the pre-money is $25M, the math works for "Big Name Fund X" (BNFX, let's call them) if they put in $10M of a $25M round, or $8M of a $15M round.
But what if the company deserves a higher valuation than that? The math starts to stack up pretty quick. If the right pre-money is really $50M, that means that $16M of a $30M round will be necessary, for example.
Here's the problem -- many of these companies don't need to take in that much capital at that stage. They may need only $10M for their Series B, not $15M or $25M, and certainly not $30M.
But should they take a lower pre-money valuation just because BNFX needs to get to a certain ownership target and they don't want to raise more than $10M? So if the insiders' pro rata is, say, 40%, that leaves only $6M for the new investor BNFX. To get to 20% with that means a pre-money of only $20M. This might be a flat, or even down round for the company.
This has several important implications.
First, it results in an institutional bias that applies to the BNFXs of the world, one that tends to steer them toward investing in companies that are raising big rounds -- capital efficiency be damned.
Second, it means that well-performing companies are pushed to take larger rounds than they need. This is healthy neither for the now-overcapitalized company, nor for returns.
Third, it means some of the best companies will turn down nice offers from even the biggest-name venture firms out there -- simply because the math doesn't work. In our example, BNFX (assuming they now believe in the overall market opportunity) must now hunt around for a lesser company in the same sector and either take advantage of their lesser standing to drive a lower valuation or convince this second company to overcapitalize themselves when BNFX's first choice wouldn't. Maybe BNFX can successfully take this B-grade company and leapfrog them over the one they preferred -- but maybe not.
This exemplifies the negative selection bias I'm talking about. It doesn't happen every time, of course -- there are lots of cleantech startups backed by the biggest name venture firms that truly are best in class, and these big firms obviously have a lot of other factors working in their favor. But because it does happen sometimes, that means that when you see BNFX invest in a company, don't assume that means that company is in their eyes the best company in that market. It just means that that was the company they could work out the math with. (Note to journalists: Do your homework before you start trolling BNFX's portfolio as a shortcut for your "best of" lists. It's a good starting point, but only that.)
There's an easy solution to this, of course, which is for BNFX to invest in the best companies at the Series A stage, and get their ownership (typically at an even higher level) starting point while the valuation is low enough for the math to be easy. Many such big firms take just this tack. But in cleantech, they've been learning that it's tough to be an early-stage investor and choose bets with confidence. This helps to explain why we've seen the significant shift away from early-stage investing. This in turns serves only to further exacerbate this negative selection bias, at both sectoral (favoring capital intensive plays) and company-specific (per the math above) levels.
And it's all because the big-name firm needs to have a significant stake of the company to make it worth their while.
Sometimes venture capital is a seriously screwy industry.